The Alternative To Consensus Thinking

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Monthly Archives: April 2013

We’ve seen quite the change in the Japanese stock market since the election of Prime Minister Abe last November. Accompanying the impressive stock rally we’ve seen change in the Japanese political line up with the new Abe regime and importantly, new Bank Of Japan leadership. The Japanese have now joined the global central banking chorus of “whatever it takes” (in terms of money printing to stimulate their economy). And like their global central banking brethren, they have been perceptually rewarded short term with gratuitous financial asset reflation. In one sense, what is occurring is a real game changer for Japan. Question being, a positive or somewhat darker game changer? That question remains to be answered.

What I hope is important in terms of thinking about the reality of change in Japan is looking beyond the obvious money printing anticipation and global institutional underweight driven stock levitation act of the moment. From a secular perspective, that’s short term noise. Can Japan really pull it off this time? Or will they potentially pull the proverbial pin on themselves?

Remember that this is not Shinzo Abe’s first time at bat as Japanese Prime Minister. When he first took office in September of 2006, the Nikkei rallied for five straight months, albeit not with the power or from the price depths of the current rally. The global economy at the time was also a different place with Japan’s largest trading partner China still rapidly accelerating, the US still in the midst of a real estate/credit cycle boom, and not a hint of smoke yet rising from the European periphery. Abe now embarks on his current policy adventure without the support of a global economy firing on all cylinders. Maybe this is all the more reason for what appears relatively radical monetary policy planning.

We found out the key points of BOJ policy last week from newly appointed BOJ chief Kuroda. The BOJ is targeting a 2% inflation rate within two years, a doubling of the monetary base (this is very meaningful), a doubling of JGB maturity purchases, a doubling of BOJ purchases of ETFs (equity indices) and REITs, and a commitment to a 7 trillion yen monthly purchase rate. This is clearly the most aggressive Japanese QE policy on record since 1990.
We have already seen some evidence of increased short term household spending domestically as clearly citizens are aware of potential monetary policy and currency volatility outcomes. And like experience in many other countries, financial asset levitation has been dramatic at the outset.

Although late by about five days, the Nikkei hit 13,000 last week – the exact price political decision makers verbally suggested they wanted to see a month and a half back. Key technical issue being near 13,000, the Nikkei has once again encountered its 200 month moving average. The 200 month MA has been meaningful upside resistance for the secular Nikkei bear for close to 15 years now. IF we are looking at positive fundamental change for the better in Japan and the equity market is correctly anticipating such an outcome, that key technical demarcation line needs to be taken out decisively to the upside. It’s probably the spot where we get a bit of volatility and testing short term.

But as we all know, the transmission mechanism of monetary policy into real economies in the global economic environment of the moment has been problematic up to this point. Central bankers have shown us they know how to reflate the price of financial and in some cases hard assets. But their fundamental impact on real economic activity and direction unfortunately still leaves a whole lot to be desired. For now, the difference for Japan singularly is an apparent strong commitment on the part of the BOJ to remain aggressive, unlike prior BOJ monetary policy excursions. So what do we look for in Japan in terms of trying to gauge whether Abe and BOJ monetary policy plans will positively impact the secular trend of the Japanese economy? Can they really pull it off this time?

Again, the lesson of the last four years appears clear. Monetary policy can move the asset price needle for a time, but has had much less impact on the fundamental reality of individual economies. Why has this been the case? Although it’s just my personal opinion, if we look at the experience of Europe and the US just what has been lacking? Reform. Europe has thrown pieces of money at hotly burning short term financial/economic/banking system fires mostly in peripheral countries, but has done absolutely zero to reform the key infrastructure of the Euro system itself. In like manner, the US has done nothing to reform the TBTF financial sector 800 pound gorilla’s as their ever expanding girth remains a key systemic issue. Reform of debt, deficit and entitlements at the government level stateside? The sequestration is lip service compared to what is actually needed and will ultimately be accomplished one way or the other. Key issues of reform avoided….for now. Is this the reason why achieving economic “escape velocity” has been so elusive?

So as we look at Japan I would suggest to you that beyond money printing and the global institutional investment underweight in Japanese equities impacting current price, real fundamental economic change in Japan will come with reform and deregulation. This is what would turn a momentum rally into perhaps the beginnings of a longer term bull market. Money printing can certainly gin up stock prices, but sustained economic change must be driven by reform. This is where the Abe rubber will meet the road.

Although this is an incredibly short and certainly incomplete list, what needs to be done? Corporate tax reform. The stimulation of business fixed investment. True change in constricting labor rules and regulations (is there an echo in here from France?). The opening of markets to foreign investment and competition. Reform in immigration policy as Japan’s demographic issues still loom large. The rally in the Nikkei up to this point has certainly been fun, but attacking and successfully navigating these issues of needed fundamental economic reform will not be accomplished in such linear fashion. There will be bumps in the road, as is the case in any environment of true fundamental change.

In addition to fundamental economic reform, the Japanese corporate sector must also act to become more shareholder oriented in terms of capital allocation. The quality and action of corporate governance is key here. M&A focused at least in part on productivity, share buybacks and increased dividends would all play a part at the margin in a potential rerating of Japanese equities relative to global equity valuation metrics.

Does Japan have the potential to break the chains of its multi-decade economic malaise? Indeed it does, as do its developed economy brethren. True fundamental economic reform is the key. The political will to print money is an easy one, but the heavy lifting of true economic reform is another story all together, exactly as we’ve witnessed in the US and Europe so far into the current cycle.

The risk, of course, for Japan, is monetary debasement in the absence of true fundamental reform. We’ve seen the Yen weaken meaningfully since last October and that has clearly sent Yen based capital in motion globally. We’ve seen a very meaningful increase in short term JGB price volatility, as witnessed relatively dramatically last week. In the absence of true reform, I suspect we’ve only seen the beginnings of Yen based capital flight globally, which of course has ramifications for global asset markets. There is no question in my mind that Abe and the BOJ are not acting in isolation. They’ve clearly received the blessing of the US. Remember the swaps Bernanke arranged for the Euro community a few years back? You can bet there are a few tricks up central banker sleeves to attempt to quell any type of market dislocations ahead. But again, coordinated central bank actions can really only influence the short term. The long term is all about the reflection of fundamental reality. In one sense, stop watching the Nikkei and start watching for real change and reform in Japanese domestic economic policy, none of which was discussed by the BOJ last week.

I’ll leave you with one last and perhaps too simplistic thought. Historically, true equity bull markets correctly anticipating economic cycle acceleration have often been led by financial stocks. That’s one thing that has not been seen in the US and Europe over the current cycle, of course suggesting the underpinnings of the cycle are unlike historical experience. In Japan, two lead financial sector sled dogs are Nomura and Mitsubishi Financial, whose charts are seen below. Interestingly, we see a positive divergence on the monthly charts between price action and both the RSI and MACD measures over the entire 2009 to present cycle. Admittedly we saw this same technical set up for Mitsubishi in the early part of the last decade. They have certainly dutifully rallied along with the Nikkei, but if we are even close to seeing the beginnings of true secular change in Japan that necessarily must be accompanied by real reform, these two are just getting started. Stay tuned.